2/11/2010 @ 1:40PM

The Next Generation Of REITs

A crisis is a terrible thing to waste. That isn’t just a sentiment suitable for the White House; it could be a slogan for the commercial property business. Some smaller, not very well known real estate investment trusts are capitalizing on the worst downturn in two decades in ways that could enrich attentive investors, even as better-known landlords struggle to survive.

Our longtime partners at Green Street Advisors, a securities research firm in Newport Beach, Calif., have since January 2007 added 17 smaller REITs to the list they follow in North America. These newbies have market valuations between $175 million and $4.4 billion and pay dividends of up to 7.6%. Most of Green Street’s newly covered REITs (which were founded as far back as 1992) showed admirable discipline during the bubble years and now have debt representing less than 60% of assets.

Like baseball players just breaking into the majors, rookie REITs tend to trade at a discount to marquee names. Some of these REITs may eventually emerge as industry all-stars and fetch premiums. A more likely scenario for most is that they’ll eventually attract buyout bids from bigger firms.

If there’s an A-Rod in this bunch, it’s
Corporate Office Properties Trust
, whose shares have returned an annual 22% (including reinvested dividends) since 1999. The Columbia, Md. company owns 19 million square feet of office space and specializes in defense and intelligence rentals.

The founders of Corporate Office struck upon the idea in 1998 and got a big boost three years later when the Sept. 11 terrorist attacks sparked a rapid expansion of the nation’s security industry. Spooks, it turns out, won’t even commence talks unless prospective landlords already have security clearances (key Corporate Office Properties executives have them). They also insist their digs be nondescript with single, well-secured entrances; steel-reinforced ceilings, walls and floors; and sound-masking windows to prevent eavesdropping.

Demand for Corporate Office Properties’ buildings, which fit this M.O., has remained strong even during the downturn. Most office landlords are expecting 10% to 20% drops in adjusted funds from operations. (AFFO, the standard earnings measure for REITs, is net income with depreciation added back and one-time gains and property maintenance costs subtracted.)

In contrast Corporate Office Properties is likely to see its AFFO decline only 4% this year but make that up, and possibly then some, the following year, figures Green Street. The $1.79 a share in AFFO expected for 2011 is more than enough to cover the REIT’s 4.4% dividend yield.

Two other property owners that have attracted Green Street’s attention are headquartered in Canada, whose economy and property markets have been laudably unexciting of late. RioCan REIT, based in Toronto, owns 18.6 million square feet of shopping centers. That’s a mere one-tenth of what U.S. shopping center giant
Kimco Realty
Trust owns, but it’s also 10% of Canada’s entire retail footprint. That gives the REIT some leverage when sitting across the table from retail chains like Famous Players, Metro and Zeller’s.

RioCan’s AFFO will rise 9% this year, to $1.19 a share, and another 10% next year, figures Green Street. That compares with an outlook for RioCan’s U.S. strip-center rivals to suffer average 19% declines in AFFO this year and 5% next.

RioCan has had a habit of “playing it soft with rent increases,” notes Green Streeter Jim P. Sullivan. The practice, aimed at minimizing vacancies and pleasing the company’s dividend-minded retail shareholder base, put RioCan well behind U.S. rivals in boosting property income and values during the boom. Its strategy is paying off now, however, as RioCan holds on to its tenants.

Meanwhile RioCan has been using a strong balance sheet to do income-boosting deals south of the border. It paid $180 million recently for 15% of Cedar Shopping Centers of Port Washington, N.Y. and 80% stakes in two of the company’s strip centers. RioCan’s shares were recently trading at 16 times Green Street’s 2011 AFFO estimate. That is slightly below the 17 average of its U.S. peers. The shares have a 7.1% dividend yield.

Boardwalk REIT, based in Calgary, Alta., owns 36,400 apartments throughout Canada and is the nation’s largest residential landlord. The apartments aren’t fancy–rents average $1,000 a month–but they produce a stable stream of income.

Boardwalk’s AFFO will slip only 2% this year and should be flat in 2011, versus an average drop of 17% and 4%, respectively, for its U.S. rivals. At a recent $38, Boardwalk is trading at 25 times Green Street’s 2011 AFFO estimate. That’s slightly above average for an apartment REIT. The stock’s 4.8% yield is above average.

BioMed Realty Trust
, of San Diego, owns 10.5 million square feet of medical labs and offices on the East and West Coasts. Housing doctors and drugmakers is not altogether recession-proof, and weak rental income is likely to drive down BioMed’s AFFO 18% this year. Next year it is expected to rebound nicely, however.

More important, BioMed’s shares are trading at a 6.4% discount to portfolio-liquidating value, says Green Street analyst Michael Knott. This comes at a time when shares of
Alexandria Real Estate Equities
, BioMed’s larger rival, are priced at a 12% premium.

Piedmont Office Realty Trust in Atlanta is the offspring of a “nontraded REIT” created by master salesman Leo F. Wells. He paid a network of brokers hefty commissions a decade ago to convince legions of small retail investors to buy shares in Wells’ REIT for $30 each. Similar to stakes in limited partnerships, they were not publicly traded, although Wells vowed to use the cash to buy office properties, pay 7% dividends and eventually list a full-fledged REIT.

The plan hasn’t worked out too well for Wells’ investors. Since 2003 Wells’ nontraded shares have lost an estimated 40% of their value, although dividends bring the annualized total returns to about 2%. That’s about even with inflation but well below the 6% annual returns for publicly traded REITs over the same period.

The REIT was recently rechristened Piedmont and is being run by former Wells lieutenant Donald Miller. It owns some fabulous real estate, including the
Aon
Center in Chicago, and is finally on deck to go public around the time this magazine appears, at an expected offering price of $16 to $18 per share. Green Street’s Knott recommends the shares at up to $17. That’s a modest discount to the $18-per-share net asset value. In contrast, rivals with strong track records trade at 30% to 40% premiums. It’s probably only a matter of time before one of the office operators on our list of large REITs gobbles up Piedmont at a nice markup.

THE UPSTARTS

Green Street has initiated coverage of 17 REITs since January 2007. Right now the firm considers shares of the nine below to be attractively priced. Most trade for less than the 22% premium to NAV that the average REIT share currently enjoys.

REIT | MAJOR PROPERTIES

RECENT PRICE

PREMIUM OR DISCOUNT TO NAV*

DIVIDEND YIELD

AFFO** 2010E

LEVERAGE RATIO**

ACADIA REALTY | strip malls

$16.36

13%

4.4%

$0.95

45%

ALEXANDRIA REAL ESTATE | lab space

60.72

12

23

2.90

53

BIOMED REALTY | lab space

14.74

-6

3.8

0.76

52

BOARDWALK REIT | apartments

35.54

15

4.8

1.43

56

CANADIAN APARTMENT PROPERTES | apartments

13.36

19

7.6

0.66

69

CORPORATE OFFICE PROPERTIES | offices

36.05

41

4.1

1.69

58

HEALTHCARE REALTY | health care

21.36

5

6.1

1.17

48

PIEDMONT OFFICE REALTY**** | offices

17.00

-4

7.4

1.08

30

RIOCAN REIT | strip malls

18.31

37

7.1

1.04

52

Prices as of Feb. 1. *Net asset value. **Measure of profit: Adjusted funds from operations are net income plus depreciation, less nonrecurring items and maintenance-level capital spending. ***Total liabilities net of cash as a percentage of current value of assets. ****Piedmont figures assume initial offering at $17 per share.
Source: Green Street Advisors.